Through the looking glass of fund costs
Be prepared to ask the hard questions about your fund's fees and charges, writes John Cradden
If you're putting money into an investment fund for the long term, you could do well to pay more attention to its fees and charges than to the promised returns. Whether it's a pension fund or any other type of investment fund, a big problem for investors is the huge difficulty in comparing fees and charges - not to mention getting to the bottom of all of them.
At least part of the reason for this is the different measures of cost that are used to inform investors. This confusion that this generates will cost you money. Fees and management charges in many cases can be so high as to eat into as much as 65pc of the fund growth of someone paying into, say, a private pension over a 35-year period.
Frank Conway of Irish Financial Review, who also runs the financial literacy initiative Moneywhizz, has spent some time analysing investment fund charges.
He calculates that if you paid 10pc of your salary (half of that paid by your employer) into a defined contribution company pension fund over 35 years, and with the total ongoing fees and charges amounting to some 3pc of all the contributions made (and assuming annual growth of 6pc), those fees would eat into a staggering 65pc of your total returns.
"For somebody earning €50,000, not even factoring in wage inflation, you would be looking at them losing €250,000 to €300,000 over the 35 years. So it's quite a lot of money at stake," he said.
"The real issue, ultimately, is can you get to the bottom of what all the fees and charges are? Are there over-performance fees - and what exactly are those? And I think that's what everybody is having quite a lot of difficulty in working out."
Many investors assume that the annual management charge (AMC) is the main measure of a fund's annual cost, when in fact the true figure could be much higher.
As well as an annual management fee, many funds may include other charges, such as an entry fee (also known as allocation rate), which is a charge for every time you invest money in; an exit or redemption fee, which is charged when you want to take out your cash; and an early encashment fee if you want to take out your cash before the end of an agreed investment period.
If you access a fund through a broker, which most of us do, there will be fees for them too.
"What most brokers do is add on a 'trail' fee to the management fee, say 0.3 or 0.5pc," says Michael Bradley of Clear Financial. "So what that means is that as long as the client keeps their fund going, the brokers get a little part every year - whether there is a fee to the client or not and whether the fund grows or not."
This means that it is hugely important that clients take the time to ask the broker exactly how he or she is being paid and what all the applicable fees and charges are, he said.
If you use an online platform through which you buy and sell investments, such as Davy Select, there will be a 'platform' fee to access it.
You may have to pay transaction fees, which are trading expenses charged to an investor when buying or selling shares of stocks, mutual funds and ETFs (Exchange Traded Funds).
There may be performance or 'incentive' fees to consider too, which are more likely to be found in 'actively' managed funds. These are paid to fund managers when they achieve certain investment returns on the funds they manage.
But these are just the explicit costs. Where it gets really opaque, says Conway, is in trying to figure out what he calls the "implicit" costs.
For example, the way a company operates its bid offers on behalf of clients may well influence the cost - do they buy investments at particular points or set dates or do they spread that over time? He believes that companies that do the latter tend to be better value.
In general, given the difficulty even well-educated and informed financial consumers have in deciphering all the fees and charges that apply to them, Frank Conway says there is a discernible shift towards funds that are 'passively', rather than actively, managed in the belief that the fees will be lower.
He points to Warren Buffett's infamous $1m bet - started eight years ago - with a US hedge fund manager that an inexpensive index fund that tracks the S&P 500 index would do better over 10 years than a group of five high-fee hedge funds picked by the fund manager.
The index fund was up 66pc from 2008 to the end of 2015, compared to just nearly 22pc for the hedge funds.
However, there are signs that the investment firms will be forced to become much more transparent about their total fees and charges, with some acknowledging that the AMC is not an accurate reflection of the total cost of investing in a fund.
An EU directive called MiFID II (Markets in Financial Instruments Directive), which the Central Bank has said is due to come into force here in 18 months' time (January 2018), will aim to make all charges for investment fund management and advice clearer and more transparent, among other things.
Although more acronyms may seem like the last thing ordinary investors need, it is possible that firms could be required to use 'all-in' fund cost measurements like TER (Total Expense Ratio) and OCF (Ongoing Charges Figure), rather than the more traditional annual management charges (AMC).
At the moment, there are fewer than 10 firms offering low-cost funds based on an OCF 'all-in' fee structure, according to Frank Conway.
He says all of the fund providers would acknowledge that there are many products, particularly older pensions, that are too expensive and are competing with each other to bring fees down.
"But I think there's more work to be done in terms of actually getting people to understand, first of all, what the OCF is, or the TER, and then, of that, what is the best route to actually growing your money. And that's often the passive route," he says
What's the difference between OCF and TER? Not very much, he adds, except when it comes to performance fees.
"In the case of the OCF, they are included; in the case of the TER, they are not."
Conway used the OCF in his calculations for the pension example above. He says the entry charge is 3pc but that this is of little significance to the long-term growth of the fund and the same is true for many other once-off charges. But if the ongoing fund charges are high, that will have a much bigger impact on the returns.
"It's just the same as if one were constantly clipping that oak tree - it will remain in a severely stunted state as long as the trimming continues," he said.
The Sunday Independent spoke to a number of other advisors, all of whom agreed that OCF or TER is a much more accurate reflection of the fees and charges applied by an investment fund manager - particularly for actively managed funds - but that not everyone uses it or understands it.
"I do use TER and OCF all the time," says David Quinn of Investwise. "It's very difficult but not impossible to get that information for Irish investment providers."
The information is widely available in most other jurisdictions, he added, while it is obligatory in the UK. "As Standard Life are a UK firm, it is relatively easy to get their data."
Michael Bradley says more investors are taking advantage of greater online access to information about their funds through providers' web portals (some of them require pin codes), which has helped to inform them enough to the point where they can ask more questions about fees and charges at any time.
In the past, they may have had to rely on end-of-year statements sent to them in the post.
Given all the many different investment fund fee structures that exist and the difficulty in comparing them without the help of a honest and patient broker, are there any simple questions you can ask a broker or advisor to help ensure you get the full picture?
Frank Conway suggests a couple.
"Can you give me all the fees? Or another way we think maybe people should be probably asking is: can you guarantee that there are no other fees around this?"
Sunday Indo Business